Berkshire Hathaway and Swiss Re have finalized the terms of the funding arrangement initially announced on February 5, 2009.  While the main elements of the deal have been known for some time, this is a good opportunity to revisit the terms of the arrangement and the overall nature of this investment.

Berkshire Takes 3 Percent Stake in January 2008

In January 2008, Berkshire Hathaway took a 3 percent stake in Swiss Re and also agreed to take 20 percent of Swiss Re’s property and casualty business for five years.  At the time, this move was interpreted as a major display of confidence in the quality of Swiss Re’s underwriting capabilities.  Berkshire purchased the 3 percent stake on the open market and Swiss Re traded around CHF 76 when the initial investment was announced.  Since that time, Swiss Re shares have plummeted and closed at CHF 14.88 on Friday, March 13. 

By January 2009, Swiss Re was in danger of losing its AA Rating due to heavy investment portfolio losses suffered during 2008.  The decline in capital related to mark to market losses on the investment portfolio in 2008 more than offset strong underwriting results.  This led to the current capital infusion from Berkshire that was finalized late last week.  Swiss Re’s press release on February 5, 2009 goes into more detail.

Terms of Funding

The terms of the funding arrangement for this transaction look quite similar in many ways to Berkshire’s recent transactions with Goldman Sachs and General Electric.  Berkshire is making an investment in a new security that is senior to Swiss Re common shares but junior to all other senior securities in Swiss Re’s capital structure. 

The convertible preferred security in the amount of CHF 3 billion bears fixed interest rate of 12% per annum and has the following additional terms:

• The security is perpetual and has no maturity date or term.
• Swiss Re has the right to defer interest payments.  For all interest not paid on an original interest payment date, an additional amount will accrue on delayed or deferred interest at the rate of 15% per annum.
• Swiss Re has the right to pay interest in shares in lieu of cash and such shares will be valued at 95% of the average daily price per share for the five trading days prior to the interest payment date.
• Berkshire has the right to convert into shares starting three years after the issue date.  The conversion price will be CHF 25 per share, which was the price of Swiss Re shares at the time the deal was initially announced.
• Berkshire is protected from a number of potentially dilutive events detailed in the terms sheet.
• Swiss Re has the right to repurchase the security on or after the second anniversary date of issue for a 20% premium.  Prior to the second anniversary, Swiss Re would have to pay a 40% premium. 

It appears that Berkshire has obtained a security senior to the common stock paying a low double digit interest rate along with a conversion option that could result in a nearly 25% ownership interest in Swiss Re.  While the conversion price of CHF 25 is far above Swiss Re’s current share price, a combination of an eventual recovery in the investment portfolio and continued strong underwriting results is likely result in a profitable conversion at some future point. 

Since the convertible security has no expiration and can only be repurchased by Swiss Re at a significant premium, Berkshire should be able to profit from future advances in Swiss Re’s share price while retaining protection of a security senior to common shares in the capital structure.  It appears that Warren Buffett has again structured a deal in which he retains the upside of a common shareholder while enjoying the protection of a senior security. 

Buffett “Delighted” with Transaction

Warren Buffett was widely quoted as being “delighted” with the Swiss Re transaction when it was announced in February.  At that time, the conversion price was equivalent to the share price around CHF 25.  Immediately after the announcement, Swiss Re shares declined significantly.  In addition, Jacques Aigrain, Swiss Re’s CEO resigned on February 12.  Aigrain was replaced by Stefan Lippe who was Aigrain’s deputy at Swiss Re and has a long history in the reinsurance business.  In recent days, Swiss Re’s Chairman was also replaced. 

Whether this plays out well for Berkshire will obviously depend on Swiss Re’s business results but one must again admire Buffett’s ability to craft deals that retain significant upside while securing protections unavailable to common equity holders.  Berkshire is putting large amounts of cash to work at double digit rates of return in senior securities.  This is sure to have a significant impact on investment income in 2009.